Fundamental or Technical Analysis: Trading ETF's

Should investors look at ETF's on a fundamental basis or is it better to use technical analysis?

Background

One of the major changes in sector investing in the last several years is the rise of Exchange Traded Funds (ETF's).  These days there is an ETF for almost anything, and new imaginative offerings appear regularly.

It is now attractive for an investor to construct an ETF portfolio instead of buying mutual funds, and there is plenty of advice.  A good place to start is the excellent guide written by David Jackson of Seeking Alpha (full disclosure:  regular readers know we contribute to and support Seeking Alpha).

Our company has specialized in sector trading for nearly ten years.  We have used Fidelity Sector funds, baskets of stocks of our own device, and more recently, iShares.

Trends in Sector Investing

Our experience has encompassed some changes in sector investing, including the following:

• The early period, where large mutual funds gained edge by identifying secular sector moves.  Their problem was the time it took to alter massive portfolios.  Even though they disguised their specific trades, the sectors they were buying always had a strong underlying bid.  Those they were selling had a strong offer above the current market.  Our software detected this and we benefited from multi-month sector trends.
• The outflows from individual investors have reduced this effect from major funds.
• Financial advisors and individual investors now construct their own ETF portfolios.
• Hedge fund managers use ETF's instead of futures.  Those of us schooled in the Chicago tradition of options and  futures trading find this amazing, since futures have some clear advantages.  Nonetheless, those who blog or write trading diaries buy (or sell) SPY or QQQQ to get long  (or short) the market.  When they are bullish about oil, they buy XLE rather than oil  futures.

The Result

Those trying to use fundamental analysis on ETF's do not have their complete tool kit.  Many such investors are trying to time the business cycle or have been encouraged by TV ads to believe that they can have a "feel" for these markets.

The standard metrics -- book value, P/E ratios, cash flow analysis, etc. -- are lacking, at least until some research services come up with cap-weighted metrics for the funds.

Hedge fund traders in ETF's represent "hot money" since the shifts can be quite rapid.

Our Conclusion

For our clients we use both fundamental and technical analysis.  For individual accounts, technical analysis helps us with entries and exits from positions where we have a fundamental position.

ETF's are different.  We find that technical analysis is far superior for ETF trading.  Our technically based TCA-ETF model is the basis for one of our funds, with an average holding period of about thirty trading days.

This approach has worked well on various baskets, but we recently decided to apply it to iShares.  Since the back testing for this new universe (not even contemplated when the model was developed) was very positive on a risk/reward basis, we have embraced these sectors.

Every method has an appropriate time frame.  Each investor has a different time horizon.  For accounts without tax consequences, the more frequent trading suggested by technical analysis has major advantages.

Our Position

In an effort to educate our audience, which includes many who want to have a system, we have been sharing the major calls of the TCA model, including the stumbles as well as the successes.  This is important, since any system trader must have confidence in the  method.  Every system will have losing streaks.  Lacking confidence, the trader will bail out at the wrong time.  Confidence and discipline are the keys -- including strict exit criteria.

The method is designed to get on the right side of major moves and get out before major losses.  Here are the current holdings and results:

The model also recommends about twenty other sectors.  It correctly positioned us for the recent gains.

We will elaborate further on alternative sectors and overall rankings on a weekly basis.  At the moment, this is a "thinking out loud" experiment, where we examine system trading and the best uses of technical analysis.

Comments

[options trading]

Both should have a balance, trading should never be a guessing game. Always plan ahead before making your move.

[stock trading newsletter]

I think a combination of both works best. Is the technical following up the fundamentals? If not then I quesiton why.

[Options Swing Trader Tony]

TA

How are you going to know where to get in and out if you don't use TA and Charts?

So your emotions then take over (which are 99% wrong in trading decision making) and you have to super exact entry and exit method - you're hosed!

Tony

[Michael Calhoun]

TA seems paramount. I hope your list of futures advantanges follows soon.

[Greg Simonds]

Interesting post. All too often all we see is a link to somebody's product. I thought it might be helpful if people interested in Stock trading had a place to go to see a large selection of software products. Maybe this will offer users diversity in the choices available to them. here's a commercial site with some tools not everyone is awate of:
http://StockIndustryRatings.com

[Greg Simonds]

Interesting post. All too often all we see is a link to somebody's product. I thought it might be helpful if people interested in Stock trading had a place to go to see a large selection of software products. Maybe this will offer users diversity in the choices available to them. This is a commercial URL, but it has some tools that no everyone is aware of.
http://StockIndustryRatings.com

[Michael Glass]

I tend to be more of a technical investor. However, I do think it's important to look long term first and make entry/exit decisions of shorter term charts. Even a fundamental investor should use technical indicators to help fine tune his entries and exits.

For example, on the weekends, I look at each of the major sectors to see which one are trending up or down. I then find stocks within those sectors that are moving for further review.

Then after setting entry/exits points of the daily charts, I use 15 and 5 minute charts to make my entry.

Effective Trade plans delivered daily from AccendoTraders.com

[real time stock options trading]

I do agree that TA plays the most important role in any ETF trade.

[Bill aka NO DooDahs!]

I'll add tax treatment and an easy one-stop-shop for market-tracking to leverage and arbitraging the cash/fair value split, and look forward to the articles.

[oldprof]

Bill-

OK, I'll put the advantages of futures on the article list. I think I have mentioned the subject a few times. Dan Rostenkowski (former chair of the House Ways and Means Committee during the formative stages of the Chicago markets) had a hand in developing the relevant law. Margin requirements and tax treatment are important. Liquidity and the speed of reaction of the markets is also big.

If a trader on vacation calls in for a market update, the report always starts with:

"Spu's are up 6.50......"
or whatever is appropriate. It is the single best equity indicator for stocks and a liquid means of trading QQQQ's, bonds, oil or whatever. Much better for traders than ETF'S.

It can be a pain to do the compliance to open a futures account, which may be why some of the NY guys do not bother.

On the sector fundamentals -- let's both watch to spot anyone really doing this!

Thanks,

Jeff

[oldprof]

Josh-

Thanks for the comment. Not everyone appreciates my humor. My son is almost 16 (the old guy got a late start) and he has been schooled in what he calls "Dad humor".

With your encouragement, maybe I'll repost here.

Thanks,

Jeff

[oldprof]

Tim-

Thanks for your interest and your questions. I am trying to figure out how to provide more information about the sector choices.

I promise to follow up more carefully in a future post.

Thanks,

Jeff

[Josh Stern]

Hey, congratulations on that Will Rogers bit from RealMoney. That was hysterical!

[Bill aka NO DooDahs!]

"since futures have some clear advantages"
I'll bite. Name them. I can see the inherent leverage of the contract, and the change in relation between "fair value" and "cash" as "features," but not necessarily advantages.

" until some research services come up with cap-weighted metrics for the funds"
In many sector funds, the top ten will come up on Yahoo! and are the majority of the holdings, one could do this themselves. Or, better yet …

One could fundamentally (or more appropriately, FundaTechnically, since valuation metrics depend on a technical criteria i.e. price) scan the universe of stocks and see what sectors show up with the largest representation, and then find the ETF that is closest.

[Tim]

Jeff,
I think your sector trading model has a lot of merit and I appreciate your sharing it with us. Do you bench mark against the SPY the sector universe combined? As a fundamental investor I am using ETF as sector indicators for individual companies I am researching. Back to your model, the last 30 days have been pretty positive (at least for me), I am really interested to see how your program works in a flat or down overall market. Again, thanks for the open sharing and it appears you have a winner so inquiring minds would like to know more.